Unreal repo rate hurts?

Repo rate bites small investors

Reduced Payout by EPFO: EPFO (The Employees Provident Fund Organisation) declared interest payout of 8.1% to its subscribers for FY 2021-22. This is the lowest interest payout since 1977-78. Its regular earnings, which was 8.5% of its total corpus during last year, declined to 7.9% in FY22. EPFO consciously decided to liquidate some of its equity investments and use the capital gains of app. Rs.5529 cr. in its interest payout, so as to make it decent at 8.1%. The saving grace is, unlike in the past when pre-period reserves were also used for such payouts, the interest payout for the current FY comes out of its current earnings. 

Unrealistic returns on investments: The lowest interest payout by EPFO should not surprise anyone, who closely follow the monetary and regulatory prescriptions since 2019. In fact, I have written in my blog  https://viswoice.blogspot.com/2021/06/unreal-repo-rates-hurts-savers.html dated 14th June 2021 as under: “EPFO and accredited PF funds might find it difficult to maintain the average interest of above 8.5% paid in the last few years”. Though the CPI inflation was more than the upper band of inflation (6.0%) for a considerable period of time in the last 24 months, repo rate, which was meant to reflect inflation conditions and restore price stability in the economy, is kept unchanged at 4.0% since May 2020. As a consequence, the weighted average yield on Government Securities (G-sec) declined by more than 150 bps. (from 7.77% to 6.16%). The interest on corporate bonds (including debentures) declined by 300 bps, in case of instruments rated AA and above and by 200 bps in case of BBB and below rated ones. The move also reflected on money market instruments and enabled major corporates to raise Commercial Papers (CPs), which were raised at interest rates, far below their eligible borrowing rates. 

Determine Deposit Rates through External Bench Mark links: RBI also mandated banks to link their lending rates to external bench marks such as repo rates and forced them to reduce their lending rates to borrowers. This move had the desired effect of reducing the cost on deposits arbitrarily. The age old practice of arriving at lending rates based on cost of funds (deposits), which reflected the expectation of depositors, based on current inflation, was given a go by and the present repo rate, not reflecting inflationary conditions, was taken as the indicator to reduce deposit rates. The deposit rates of scheduled commercial banks (SCBs) dropped by 200 bps (from 7-7.5% to 5-5.5%) and savings bank interest rates reduced by 80 to 100 bps (from 3.5 to 4.0% to 2.70 to 3.0%). Thanks to COVID conditions, which forced depositors to be liquid and stay invested in bank accounts, some of the banks, which were dependent on high cost bulk deposits, improved their retail portfolio substantially at reduced costs.

Investors hit:  The raw deal handed out to the bank/ NBFC depositors was visible to the naked eye immediately, since the reduced earnings got reflected on renewed/new deposits and also as most of their deposits were held in the time buckets up to 2 years. However the impact on bigger investors (which money represented that of small savers) did not catch the attention of the public, till the final payout is made by such investors to its subscribers, as has happened in the case of EPFO now. EPFO and the other social security scheme players like pension funds and insurance companies were the worst hit, as 90-95% of their investment pattern revolves around g-sec, debt instruments and bank deposits. (Main Objective is to keep the corpus risk free) The following table makes the understanding easier::

Nature of Investment	Guideline for investment (percentage of total funds)	Decline in yield in the last 3 years
G-Sec	Minimum 45 Maximum 50	161 bps
Debt Insrumnets (should be at least  AAA/AA)	Minimum 35 Maximum 40	300 bps
Bank Deposits (subject to conditions)	Within Debt instruments above	200 bps

EPFO with a corpus of 12 lac cr. plus could still manage a total return of 7.9% (60 bps less as compared to previous year earnings), as majority of its investments were probably made prior to the decline period and did not mature for payment in the last three years. Even if the yield improves in respect of g-sec/debt instruments in 2022-23, the increase is likely to be marginal, as the market is influenced by the stance of RBI and is also flushed with liquidity. And investments that mature during this year, if reinvested will fetch much less returns. In the above circumstances, unless substantial capital gains are realised from equity investments, EPFO may struggle to keep an interest payout of even 8%, leave alone the current year's payout of 8.1%.

Pension Funds are of two types:

Defined Benefit Scheme (DBS):  Central / State governments, banks and other PSUs have covered all employees, who joined prior to introduction of New Pension Scheme, under defined benefit scheme. With fall in yields affecting the fair value of the assets under management (AUM), the institutions have to necessarily make substantial provisions to maintain their obligations. (employer should bear investment and actuarial risks). 

Defined Contribution Scheme: Net Asset Value (NAV) of AUM of the respective funds under defined contribution scheme would have taken a hit on account of decline in yields and this will have an impact on persons retiring hence, both in respect of amount eligible for withdrawal and future annuity amounts to be paid. Even NPS, a defined contribution scheme that gives freedom to the managers of such funds to invest in equities, may not be immune, as the proportion of investment between equities and debt instruments varies across different players/ different age period of subscribers and maximum permitted in equity is 50% only in whatever plan one choose to join.

Insurance: Surplus earnings added as bonus to individual policy holders will be less as major portion of the AUM is invested in the G-Sec and Debt Instrument Category.

Summary: EPFO has 6.3 cr. subscribers. NPS has 1.55 cr. subscribers under regular NPS and 3.52 cr. subscribers under APY (Atal Pension Yojana). Significant number of EPFO members would have been covered under defined pension benefit scheme. At least 25% of bank depositors would have invested in fixed deposits with the banks.  So,   the number of small savers, accounting for a sizeable percentage of population received inflation unadjusted low returns in the last three years. 

To Ponder: The financial impact, already felt by bank depositors and EPFO subscribers, is bound to be felt by the other small investors' groups, as well, in the coming days. Is the expected aim to have a growth in the economy, leaving the crores of small investors to earn at less than real rate of return (inflation adjusted), good for the country?

V. Viswanathan

25th March 2022

 How reduction in EPFO affects cumulatively

The EPFO interest payout is not paid to subscriber but added and becomes part of the outstanding balance,  which is eligible for future interests till terminal benefits are paid. So lesser interest has a compound effect of reduction till the final date of payment. 

For example, let us assume the reduction in interest income is Rs.100 (due to reduction in interest from 8.5% to 8.1%). This loss of income becomes Rs.150 in 5 years, Rs.340 in 15 years and Rs.770 in 25 years. Means the loss of income is 1.5 times if terminal benefit payment is 5 years hence, 3.4 times in 15 years and 7.7 times in 25 years. (Assuming interest at 8.5%)

2. The lesser interest payout is the begiining of less interest payment cycle that will be witnessed for the next five years, as the investments that get reinvested may get current yields, which are significantly lower.